Negative correlation is a statistical measure used to describe a relationship between two variables. When two variables are negatively correlated, one variable decreases as the other increases, and vice versa. Negative correlations between two investments are used in risk management to diversify, or mitigate, risk associated with a portfolio.

Risk management is a process used in decision making to identify and analyze the risk associated with an investment. Investors, portfolio managers and risk managers use risk management to analyze and attempt to quantify the level of potential losses associated with an investment portfolio and take the appropriate action given the investment objectives and risk tolerance associated with the portfolio.

Negative correlations of investments are used with the risk management of a portfolio to decide to allocate assets. Portfolio managers and investors believe that some of the risk associated with the portfolio would be diversified if they can assemble a portfolio of negatively correlated assets. The strategy of assembling negatively correlated assets is appropriate if a portfolio manager is forecasting a market crash or in times of high volatility.

A portfolio manager's strategy during times of high volatility is to manage the risk in his portfolio properly and combine assets to produce a low volatility portfolio. Using negatively correlated investments in his portfolio helps to reduce the overall volatility of the portfolio.

For example, a portfolio manager invests in stocks in the oil sector. However, over the past six months, oil stocks have been declining due to oversupply of crude oil, which cause oil prices to fall by 50%. He believes that oil prices will continue to fall lower and may crash in the short term. However, the portfolio manager still wants to own the stocks for long-term investing. He did not properly manage risk and is now looking to allocate his assets properly to diversify this risk. He can use negative correlations of assets to diversify the risk of the portfolio associated with the oil sector. Some sectors that are negatively correlated with the oil sector are aerospace, airlines and casino gaming. The portfolio manager may look to sell a portion of his investments in the oil sector and buy stocks that are associated with the negatively correlated sectors.

The portfolio manager can also hedge his portfolio to reduce risk. Hedging reduces the risk associated with an investment or a portfolio by taking offsetting positions. In this sense, negative correlations are used to hedge the risk of an investment. Instead of diversifying the portfolio, which can use too much buying power, the portfolio manager can use negatively correlated assets to mitigate the risk with the oil sector. For example, he may look to sell call options against his stock positions or buy put options in oil stocks to protect the portfolio and mitigate risk. Since these are offsetting positions, they are considered negatively correlated assets.